The coronavirus, or Covid-19 pandemic, has thrust the world onto a path leading to an economic collapse of epic proportions. In this constantly-updated blog we follow the progress of the crisis.
The Stage of the Crisis: The Counterattack/The Flood
Updated 16/04/2021 (previous update 22/12/2020). All updates are presented in bold.
In the December 2018 issue of our Q-Review, we outlined the likely scenarios of an approaching global economic collapse. But, like most things in life, such a dramatic event is unlikely to proceed in a purely linear fashion. There will be different stages within it.
In December 2019 we outlined these stages, which are likely five: the onset, counter-attack, flood, calamity and recovery. Here, we briefly define the characteristics of each, updating them with recent information.
The Onset of the crisis
In the Q-Review 4/2019, we specified that at the onset, stresses that had been building in the credit markets since the summer of 2019 would explode, shrinking if not eliminating entirely the exits from many parts of that market.
Downgrades of corporate debt in the U.S. and peripheral sovereign debt in the Eurozone would push large fixed-income investors, including pension funds, into higher-rated bonds, which would in turn lead to large-scale selling of lower-rated bonds, forcing wider spreads and even more selling.’
This moment came in late February 2020, when a sudden panic gripped investors in both credit and equity markets after a surge in reported Covid-19 cases and deaths in Italy coincided with the collapse of OPEC talks. Stock markets crashed and spreads in the credit markets exploded. A frantic retreat to ‘safe-haven’ assets, including U.S. Treasuries, German Bunds and U.K. Gilts as well as cash and precious metals commenced.
For a brief period of time in mid-March, we were on the brink of a complete financial market meltdown. Then, as we also had envisaged in December, there was a frantic rush on a never-seen-before scale by global and local authorities to rescue the situation.
We envisaged that the second phase of the collapse would be the desperate efforts of authorities to stop the crisis by a counterattack.
We said these were likely to include the restarting and acceleration of QE programs and other market support initiatives, gigantic fiscal stimulus, increasing trade protectionism and possibly even calls for direct debt monetization (see Q-Review 3/2019 for an explanation).
These tactics have been employed in full force. Governments all over the world have pushed vast amounts of debt-financed stimulus into their respective economies.
The massive $1.9 trillion stimulus package administered by the Biden administration will likely give a boost to the U.S. economy, but it is completely artificial in nature. Jobless claims fell to 576k in March, a pandemic low, but still close to the pre-pandemic peak of 690k.
The Fed has become the financial market (see Figure 1) as it backstops U.S. Treasury markets, intervenes in corporate commercial-paper and municipal bond markets and short-term money-markets. Massive support by the FED and the “free money”-schemes of the government have levitated U.S. stock market valuations to levels not seen since, at least, the height of the “Tech Boom” in 1999.
China also enacted a massive stimulus programs in March, which has been kept running full-blast (see Figure 2). The infrastructure investment programs in China have been the single most important factor behind the recovery of the manufacturing sector across the globe.
The ECB has increased its ‘Pandemic Emergency Purchase Program’ to a €1,850 billion behemoth, and it considers of extending the program even further.
While the European leaders reached an agreement on the €750 billion “recovery fund”, it will still need to pass all 27 national parliaments. This is far from certain.
The Eurozone, with its massive and teetering banking sector, is the ‘weak link’ in the global Counterattack. As, most of Europe is back in lockdown, this will not spell good news for the banking sector.
Regardless of the desperate efforts of global authorities to uphold the credit and stock markets, we are still facing a flood of corporate bankruptcies.
In December 2019, we asserted that the so-called “zombie” corporations, faced with collapsing global economic demand will start to fail on a scale unseen in decades. Unemployment will skyrocket and tax revenues will collapse. And, at some points, credit markets will crash despite of the massive efforts of central banks. We also envisaged that:
If one or more European banks weakens or fails, it will be likely to send the capital markets into a similar downward spiral.
When the coronavirus erupted in early 2020, leading to lockdowns across the globe, the world economy was confronted by an unexpected and artificial depression. This naturally would have been enough to topple zombie corporations, but the situation was salvaged by massive government stimulus programs and central bank support of enterprises.
Through these measures, the probable evolution of the shock of lockdowns and pandemic into a global banking and economic crisis was stopped. However, the price of these drastic measures, as explained above, was that they created hordes of zombie corporations across the globe. Alas, the zombification problem has, most likely, been exacerbated as a result of these interventions.
For example, according to the data compiled by Deutsche Bank Securities in the U.S., the number of U.S. publicly traded companies classified as zombies has risen to close to 19%. By November 2020, U.S. zombie corporations sat on an incomprehensibly large mountain of $2 trillion in debt. The number of publicly listed zombie companies had also swollen by 200 since the start of the pandemic.
At the end of 2018, over 76,000 state-owned enterprises (SOEs) were making a loss and could be classified as zombies in China. This is a stunning figure, because at the end of 2017 China had a total of around 150,000 SEOs.
Incredibly, around 50% of China’s SOEs were likely to be zombies, even before the bailout operations during the pandemic. While China let 6 percent of all companies fail during the first half of 2020, this constitutes only a marginal reduction in the zombification problem, which is likely to have continued to grow during the latter part of 2020 and into early 2021.
Alas, the zombification of the global corporate sector was already widespread and accelerating before the pandemic. With massive government bailouts and overwhelming central bank meddling during the pandemic, the world economy is now likely awash with zombie corporations.
When corporate failures, or the Flood, or the Tsunami, truly begin, this will be visible both in the financial markets and in the public sector.
Several sectors of the financial markets are likely to witness massive turbulence, collapsing prices and even complete implosion.
The Fed and other central banks may be able to uphold the financial markets, but their ability to stem a banking panic is very limited.
In reality, central banks can only provide liquidity and try to establish a ‘bad bank’ to collect non-performing assets from bank balance sheets, but if the problems of the banking sector are widespread, as they now are, these methods will be insufficient to stem the ‘bank run’. Only governments can truly solve a banking crisis, by, for example, providing fresh capital to banks, but many are heavily indebted now, especially in Europe.
An utter economic collapse, Calamity, will follow.
Massive global deflation will appear, led by an ugly chain of bank and corporate failures. Global liquidity will collapse and stock markets will crash in a spectacular fashion.
The value of the holdings of public and private pension funds, charitable endowments, bank trust funds, insurance company general and variable accounts, and stock and bond mutual funds will crash in short order in the Flood. Even lowly money-market funds may be at risk, just as they were in the 2008 financial crisis.
Due to both crashing capital markets and banking sector bankruptcies, joblessness and poverty are likely to explode. Simultaneously, government tax revenues will collapse as incomes retreat and capital gains evaporate.
As governments spending skyrockets in an orgy of Keynesian counter-cyclicality, national deficits will hit all-time highs on both an absolute and relative basis. Those central banks that have initiated debt monetization will have no alternative but to accelerate their programs. In their desperation, many other central banks are likely to follow.
Governments will try to save critically-important banks, which will require large-scale funding many countries—such as those in the Eurozone—cannot afford and will not be able to finance in paralyzed capital markets. This economic reality makes depositor bail-ins the only, if politically-unpalatable, option.
Confronted by new and harsh fiscal realities, pensions and other social security programs are likely to face serious cutbacks, by desperate governments. An economic calamity sets in.
However, even grimmer scenario exists, because two of the main drivers of fast or even runaway inflation have started to emerge:
- Excessive growth of money in circulation
- A broad reduction in productive capacity
The balance sheet of central banks has swollen during the past year due to the aforementioned QE programs.
Production capacities may be hampered by forces that push companies into bankruptcy. One of the most historically common and pernicious is war, such as the Great War which contributed to the hyperinflation in the Weimar Republic between 1919-1924, or the economic crash caused by the collapse of the ruling Communist political system, which preceded the Russian hyperinflation in the early 1990s.
However, production capacities can also collapse due to the large-scale failure of zombified corporations, and this is one of the (many) risks we are running now.
Extreme inflation episodes can be stopped only by curtailing the flow of credit into the economy, and possibly by changing the currency used within the country concerned.
The only option for central banks would be to terminate all support programs and raise interest rates rapidly. This would, most likely, lead to an epic crash of both the capital markets as well as the zombified corporate and banking sectors. ‘
An outright economic calamity with serious degradation of living standards would follow.
If the full socialization of our economies and financial markets does not occur, we expect the global depression to last 3-5 years. The initial collapse is likely to be over within three years (2020-2022).
Thus, the path to recovery will depend crucially on how far the ‘cleansing’ of the economy, markets and financial sector is allowed to go. If the banking sector implodes completely, the economic deficit will naturally be made much deeper leading to a systemic crisis.
However, if the essential functions of the banking sector are sustained, especially in Europe, we could avoid the deepest malaise. Moreover, if unsound banks and “zombie” corporations are allowed to go under or are wound-down methodically, it will clear much of the malinvestment from the economy, creating the foundation for a strong and sustained recovery.
So, if we manage to return to the principles of the market economy including, most crucially, a return to undistorted price discovery in the capital markets, we are likely to see one of the most powerful recoveries in global economic history. It would be led by robotization and general technological innovation, which hard economic times tend to foster.
Additionally, debt monetization, helicopter drops, CBDC, and other money-conjuring and take-over schemes would corrupt the economy, further making a sustained recovery impossible (see more from Q-Review 12/2020). This, unfortunately, is the path we currently are on.
Moreover, with the governments and the central banks assuming a much bigger role in the economy and society in this darker scenario, some form of fascism (which is, by definition, the merger of state and corporate power) would be the likely end-result of these developments.
We can do nothing more than hope that wise, courageous and far-sighted political leadership will spare us from that horrible fate.
Following the coronavirus outbreak, junk bond yield-spreads shot-up. They were tamed by massive support operations launched by the Fed, which have also pushed stock markets to new heights (see Figure 3). Financial markets of the US are starting to look extremely stretched.
There are several uncertainties lurking below the surface that could manifest themselves as shocks, or notorious ‘Black Swans’, toppling the fragile financial sector.
Possible shocks to the political system include wide-spread rioting, rejection of the EU’s Recovery Fund or major political scandals. Possible shocks to the financial system include renewed problems in the repo-markets, a stock market crash or credit market collapse.
Possible economic shocks include the appearance of fast inflation, a “flood” of corporate bankruptcies and/or a banking crisis. Whatever shock initiates the crash, it’s likely that other shocks will appear in quick succession when the crisis gets going.
Due to the current extremes in financial markets, renewed lockdowns and political instability in the US and in Europe, our “guess-estimate” is that the financial sector problems will re-emerge between Q2 and Q3.
All-in-all, this year may bring political and economic earthquakes not seen in decades.
By the end of the year, we may have witnessed the onset of the biggest institutional changes in over 70 years. Thus, 2021 may very well turn out to be the year of ‘Black Swans’.
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